Tax Compliance Strategies: Mitigating Arbitrage Risks

Tax and regulatory arbitrage are long-known strategies that allow companies to structure their businesses to take advantage of different taxation rules and regulations in various jurisdictions.

At the same time, with additional scrutiny from regulators and the implementation of the global tax reform, businesses have more constrained opportunities for these strategies while having to navigate in a state of regulatory uncertainty and complex compliance landscapes. 

This report focuses on the regulators' approach to regulatory and tax arbitrage, the impact of the OECD's Base Erosion and Profit Shifting (BEPS) Pillar I and Pillar II rules, challenges for transfer pricing, and how multinational businesses earning profits in various jurisdictions can ensure compliance.

Regulators' Stance On Taxation and Regulatory Arbitrage

While regulatory and tax arbitrage are not illegal, regulators subject these practices to scrutiny due to their potential to undermine transparency and accountability and increase risks of tax evasion. 

Once described as the "manipulation of the structure of a deal to take advantage of a gap between the economic substance of a transaction and its regulatory treatment," this critical characteristic of regulatory and tax arbitrage, coined back in 2010, continues to resonate with many regulators worldwide. 

Various sources cite concerns that regulatory arbitrage has the potential to result in tax avoidance and tax sheltering and impose costs on communities through circumventing obligations to society. Other negative implications of regulatory arbitrage include:

• The potential to undermine investors' trust by shifting operations to jurisdictions with higher risk exposure,
• Inequality of market treatment and unfair advantage over competitors,
• The potential to engage in riskier operations without required supervision or capitalization.

The classic example of Uber's arbitrage of employee status for drivers in 2017 demonstrated how businesses can subject themselves to additional governmental oversight and restrictions. 

That said, multinational businesses operating across jurisdictions need to be mindful of these approaches by regulators and take additional steps to ensure transparency and compliance at all times to avoid negative treatment.

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Regulations Limiting Regulatory and Tax Arbitrage

Over the last decade, governments around the world have been working to address the issue of regulatory arbitrage and implement changes in the taxation of multinational corporations. Some of these efforts have already materialized in global tax reform and the BEPS initiative, aiming to alter international tax architecture. 

Specifically, BEPS Pillar I regulations aim to ensure that an organization's profits are taxed in the jurisdiction where these profits are earned. Meanwhile, BEPS Pillar II introduces a minimum tax rate for corporations to be paid in every jurisdiction they operate. When combined, these regulations will reduce incentives for organizations to move their operations to low-tax countries and even out the taxation across jurisdictions.

In addition to BEPS Pillar I regulations, which are still being negotiated by several jurisdictions, and Pillar II rules expected to be included in the national law of the EU member states in 2024, there exist a number of other laws limiting regulatory and tax arbitrage, including:

• US Foreign Account Tax Compliance Act (FATCA), which requires disclosure of foreign financial assets by US citizens and disclosure by foreign financial institutions about accounts of US citizens,
• US Tax Cuts and Jobs Act (TCJA), which imposes a minimum tax on certain foreign earnings to  reduce incentives to shift profits to other jurisdictions,
• EU Anti-Tax Avoidance Directive, which contains rules to prevent tax base erosion and profit shifting,
• VAT Directive in the EU that requires businesses to report transactions within the EU to limit regulatory and tax arbitrage.

Other Challenges for Global Companies with Distributed Operations

Transfer pricing or setting prices for transactions between related parties, such as legal entities within a multinational organization, is another favorite target of tax authorities worldwide. 

At the same time, intercompany agreements that are supposed to document the relationships among cross-border entities often fall short due to subpar entity management and compliance work, exposing companies to risks of double taxation, multimillion-dollar fines, and business disruption.

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The sheer scale of global organizations and the complexity of transactions among their entities present another set of challenges for compliance teams tasked with ensuring readiness for transfer pricing. These challenges are further exacerbated by ongoing changes in entity structures and the transformation of intercompany relationships and transactions.

How Companies Can Prepare Themselves for Multi-Jurisdictional Compliance

Businesses and private funds using regulatory arbitrage now find it tougher to implement due to fewer opportunities available. With the global tax reform gradually unfolding, all multinational companies will be affected by changes foreseen by the BEPS Pillar I and Pillar II initiatives for international taxation. 

Companies will need to revisit their tax and regulatory compliance strategies to ensure their tax arrangements are valid, properly managed, and organized. Meanwhile, global organizations leveraging transfer pricing need to have their intercompany agreements audit-ready at all times to avoid risks of penalties for non-compliance and double taxation.

The current state of regulatory complexity and uncertainty calls for robust change management practices to navigate complex compliance landscapes. Global organizations seeking to secure multi-jurisdictional compliance need to ensure global entity governance, have a clear vision of all relationships among their entities and maintain all entities in good standing.

How to avoid costly tax penalties and legal repercussions

On the practical side, implementing suggested steps requires companies to rethink their use of technology to ensure compliance. First, global organizations working across jurisdictions need a central database for all their entities that is accessible to all teams, including legal, tax and finance. 

Businesses need effective entity management tools and regulatory filing software to maintain their legal entities and intercompany agreements and streamline their compliance work. 

Global organizations working with Athennian leverage the single source of truth for regulatory reporting, automated regulatory filing, corporate structure visualization tools, and more to empower their compliance teams to navigate complex regulatory landscapes.

For more information on how Athennian can help operate in various taxation regimes and jurisdictions, please do not hesitate to contact our team to request a free demo. 

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